The 2016 Nobel Prize in Economic Sciences has been awarded to key figures in the development of contract theory. Oliver Hart of Harvard University and Bengt Holmström of Massachusetts Institute of Technology in Cambridge, Massachusetts, share the prize for conceptual work that explains the logic of CEO bonuses, privatization of government services, and many other kinds of contracts. “They are both giants of the field,” says Bernard Salanié, an economist at Columbia University.
Contracts are everywhere in the modern world, and one of the most common is the job contract. Economists began in the 1970s to analyze incentives used to motivate employees, such as workers who are not always supervised or even a CEO whose work may be invisible to shareholders. In 1979, Holmström published what is known as the informativeness principle (as did Steven Shavell of Harvard Law School, independently), which says that pay should be based on information about effort. For example, a company’s share price by itself isn’t enough to evaluate a CEO, the price should be compared to that of similar companies in case the CEO just got lucky with a bull market. When it’s difficult to assess effort, the theory suggests, it’s better to pay more as salary and less as bonuses.
Speaking to journalists via video after the announcement, Holmström was asked about the size of corporate bonuses. “In economics, we don’t take a stand on the size of the bonuses. They seem extraordinarily high,” he said. His theories instead inform how compensation packages should be structured. The research has been “hugely influential” among economists and beyond, says economist Mathias Dewatripont, an executive director of the National Bank of Belgium, who researched contract theory for many years at the Free University of Brussels. “I’m sure that compensation consultants have been taught [these principles] in business school.”
Further work suggested that fixed pay might also be better when a job has many kinds of output, some of which can be more quantified than others; an incentive structure would lead employees to put more effort on those aspects which can be easily measured, such as teachers improving student test scores rather than critical thinking. In other work, Holmström explained in 1982 that the size of a paycheck isn’t everything. Young employees may work hard not just for money, but to make a good impression and in hopes of promotion. This theory of “career concerns” applies to politicians, as well: An ambitious secretary of state, Salanié says, may work particularly hard if she aspires to the presidency.
Contracts can’t specify what to do in every future situation, especially when unexpected. In the mid 1980s, Hart and his colleagues began studying the idea of incomplete contracts. Such contracts lay out how surprises or disagreements will be resolved, the various mechanisms—such as determining who will take control of assets—can provide incentives to parties to a contract. Among its implications, the theory neatly explains the financial structure of startups: Entrepreneurs typically have an equity stake in their companies, but they must make regular payments to their investors. This gives the company freedom to operate without investors trying to judge its immediate performance. In addition to regular payments, the investors’ risk is minimized by collateral; if the company goes belly-up, the investors have first dibs on the remaining assets. The theory of incomplete contracts “explains the real world and how it works,” Dewatripont says.
Hart and his colleagues also looked at when a government should outsource services to the private sector. Again, the analysis hinges on contracts with multiple aspects, some of which cannot be easily measured. A government won’t be particularly motivated to cut costs or improve quality, according to the model. (Not all economists agree with those assumptions.) On the other hand, a company that provides a government service has a clear incentive to cut costs, but it may do so at the expense of quality, if it cannot be quantified or rewarded. A paper published by Hart’s group in 1997 concluded that services might be better outsourced if quality declines could be averted through competition, as would be case with garbage collection or weapons productions. But if it is hard to measure or enforce standards, such as in foreign policy or military operations, then those operations are better kept within the government. The insight of this model—understanding the tradeoff of cost and quality—has broad implications, Salanié says. “That’s an important consideration for regulators everywhere.”